Are Unethical Businesses Undervalued?

Recently, I’ve gotten into a few arguments regarding socially responsible investing. The argument goes that by holding stock in these companies, one is inadvertently supporting the company’s actions. So buying a stock like General Dynamics, developer of the F-16 fighter jets used by the Israeli army, would be helping to enable war in the Middle East. Or a more high profile case whereby Harvard, Stanford, Yale and a variety of other funds have divested off PetroChina, purportedly supporting genocide in Sudan.

And its something thats only going to happen more often. Research estimates believe that the socially responsible investing market in the U.S. will reach $3 trillion in 2011. Shareholders will also increase the pressure on institutions to divest off unethical firms.

So how exactly does this result in unethical businesses becoming undervalued? If the trend towards socially responsible investing continues, demand for the stock of unethical businesses will decrease and correspondingly decrease the stock price. Unless the social effects of these businesses are somehow monetized in the future (e.g. Palestinians can sue General Dynamics for developing the F-16), the decrease in stock price will have no correlation with the company’s profitability and therefore result in the company being undervalued.

Unfortunately, buying the stock wouldn’t result in profits. The increasing prominence of socially responsible investing would only serve to drive down the stock price further and decrease capital gains…

However, where this might actually be useful would be through corporate bonds. A decrease in demand for an unethical business’ bonds will increase the yield, with no corresponding increase in risk premium. Socially responsible investing probably isn’t significant enough for it to be a genuine arbitrage opportunity, however it definitely does bear future consideration.

Is the Malaysian Stock Market due a fall?

An ETF that has interested me for quite a while has been the iShares MSCI Malaysia Index Fund (EWM). Year to date, the ETF has grown by 0.71% considerably higher than the S&P 500’s -6.5% drop so far. Seem strange? Well there are two explanations for this that to me, don’t make too much sense.

One is the belief that Asian economies have decoupled and will no longer be heavily affected by the U.S. economy. If the U.S. hit a recession, China and India’s continued growth would fill the void in demand and continue to stimulate growth. With three decades of double-digit growth in Chinese GDP that has no sign of abating and with India improving its factors for growth, the two big Asian economies should be able to survive a U.S. recession and drive growth in the region.

Yet according to history, every time the US has had a recession, the GDP of Asian countries have always declined. As noted below, all Asian stock indexes have also taken a hit far worse than that of the S&P 500.

Another reason is Malaysia’s decent growth prospects, with 6% GDP growth expected in 2007 and 2008. What isn’t mentioned is that a lot of this growth is driven through exports. In 2007, Malaysia had estimated annual exports of $169.9 billion or 47% of GDP. Its two main trading partners together, Singapore and the U.S., account for 35% of this number and both aren’t experiencing the best economic situations. Singapore recently experienced a surprise -1.2% contraction in its 4Q GDP and the U.S. may very well have experienced the same when preliminary GDP numbers come out this Thursday. Malaysian 4Q GDP numbers coming out tomorrow will shed far more light on the picture but considering Malaysia’s export-oriented economy, it wouldn’t be too surprising for these numbers to be adjusted down.

Looking at EWM, one might be inclined to believe that Malaysia has one of the most resilient economies in the world. I for one am not and am extremely bearish on this ETF.

Disclaimer: Author does not hold EWM at time of publication

Market Summary and Outlook February 19 – 22

For anyone that is in University right now, its always nice to remember that it can only get much worse when you start work… When most university students are off for reading week, the world continues to move. The financial markets only stop for a few select holidays throughout the year so when I graduate, I’d be saying goodbye to a ridiculous amount of holidays. Until I retire, I doubt I’ll ever have that much freedom again… Or unless I become a professor =P So even though I’ve been on a nice relaxing holiday this week, I’ve still kept a passing eye on whats happening…

Market Summary Feb 19 – 22

With negative data having come out throughout the week, the stock indexes looked to be going down for the week. CPI numbers were greater than expected, increasing by 0.4% and core prices by 0.3%. Philadelphia Fed Manufacturing survey numbers were at -24, below an expected -10, and the lowest numbers since February 2001. Along with the negative data, gold and oil prices hit their all time highs this week.

What saved the markets, the S&P 500 and Dow Jones just managed to finish a few points above last week’s close, was news that Ambac bailout plans were close to completion. An Ambac bailout will save the banks from further losses so its no surprise that some of the banks involved in the bailout, UBS, Barclays and Citigroup, all have a lot of debt insured by Ambac… Strangely enough Ambac are still in denial claiming that “a bailout means a company that is struggling to meet its obligations, we’re in no need of a bailout.”

Market Outlook Feb 25 – 29

There will be a ton of important economic data coming out next week. Consumer spending, PPI, Consumer confidence, preliminary GDP and the Chicago Fed Manufacturing survey. On top of that, the earnings for major retailers, Home Depot, Target, Sears, Macy’s and Target will also be released next week.

The markets have averaged a 30% drop during a recession, so even though the stock market is already down around 15% from its peak in October, data that indicates a recession will have no trouble sinking the markets further.

How Long Will the Recession Last?

According to Intrade, the market is pricing the odds of a recession at 67%. 59% of American consumers already believe we’re in one along with Goldman Sachs and Merrill Lynch. Only the economists are a bit behind at 49%…

So maybe a better question to ask would be how long will the recession last?

According to a paper co-authored by Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard University, the US recession bears striking similarities to five other large financial crisises and the US would be lucky even if it has a recession… As long as it won’t last too long… The paper uses a lot of graphs to really hammer in their point, i.e. the U.S economy is doomed, and is a very convincing argument.

Is the US Subprime Crisis so Different?

The other article that foretells imminent disaster is one written by Nouriel Roubini, professor at the Stern School of Business at NYU. Roubini’s analysis is a twelve step scenario towards a global financial meltdown. Its basically a chain effect. The housing market will crash, followed by the mortgage market, and then followed by consumer credit defaults, corporate defaults, bankruptcies, a lack of liquidity and result in the largest recession over the last quarter of a century.

The Risking Risk of a Systemic Financial Meltdown
The Twelve Steps to Financial Disaster

Its all looking rather ominious. From a very selfish viewpoint, I’d have loved a nice short recession simply because I’d be looking for a job in a bull market. Unfortunately if both of these articles prove correct, it’ll still be a difficult market when I’m graduating. Perhaps it might be a good idea to hedge my job prospects by shorting the financial sector…

Market Summary and Outlook February 4 – 8

Weekly Market Summary and Outlook for the Trading Floor Newsletter:

Market Summary

The bear market rally was brought to an abrupt end this week as Americans finally came to the realization that the U.S. might be in a recession. Two polls regarding the probability of a recession, one of American consumers, one of Wall Street economists increased to 59% and 49% respectively.

Its no wonder with the amount of negative data released this week. Factory orders missed expectations by 0.3%. Pending home sales fell 1.5% more than expected for December making it a 24.2% decline in 2007. And most importantly, ISM non-manufacturing data which accounts for almost 90% of the U.S economy dropped by 12.5 points to 41.9, the largest one month drop in its entire history. Maybe Bernanke wasn’t insane after all when he made those rate cuts. There has been some good news with the $151 billion stimulus plan having passed the senate this week but it’ll take a lot more than to improve the steadily worsening economic prospects.

Market Outlook

While the economic data that comes in next week may not be as significant as last weeks, it may just be able to convince the 51% of economists still in denial that a recession is in progress. The retail sales report, a measure of the total sales receipts of retail stores, will tell us whether the American consumer is still driving the economy forward while the capital utilization and industrial production indexes will give us an indication of production levels. More negative news will only compound the misery the stock market has undergone.

Investment Banking Hours, Investment Banking Pay

I have a Human Resources midterm coming up on Friday and was reading up on recruitment and selection. One of the problems companies face is that they have certain budgets and costs that is a constraint against hiring the best talent. With this in mind, companies have to make do by hiring less qualified people in order to fill up job vacancies.

But lets stop right there and put up this hypothetical situation. Assuming hiring a genius would cost $100,000 a year, and hiring an average person would cost $50,000 a year, and there are two job vacancies, would it make sense to hire the two rather than the genius?

Now in the investment banking world, people work 100 – 120 hours a week. Thats easily more than double what a normal 9 – 5 job would entail. So why do people go through such an ordeal? Reasons range from an interest in finance, an Excel addiction, prestige, etc… But regardless, the investment banks make sure their employees are appropriately compensated with a lot a lot of money and thus manage to attract the best talent in the world.

So why don’t these investment banks simply hire two people to do the job? It could simply be the banking way of doing things but I’m convinced its because that way they can continue attracting talent into their organizations. Investment banks are a lot like technology companies, its success depends almost entirely on the ability of its people. As such, attracting the very best is absolutely necessary for the organization’s continued survival and growth. By giving undergraduates $100,000 a year for an entry-level position, geniuses enamoured by the pay will be willing to overlook even the most insane hours.

Perhaps this is the route companies will take in the future. The aging population will be causing a labour shortage and with limited qualified applicants, those applicants will be very highly paid. In exchange for doing the work of two.

Yahoo + Microsoft

With so many people asking questions about why Microsoft might want to acquire Yahoo!, I wrote a short article explaining the possible reasons for the acquisition…

Yahoo + Microsoft? At $44.6 billion, Microsoft has offered to buy Yahoo at a 62% premium over its closing stock price before the announcement. In itself, a 62% is already incredibly expensive so in current market conditions what could possibly justify such a massive premium?

Perhaps the current market conditions are the very reason why Microsoft has grabbed this opportunity to buy Yahoo. 62% may seem like a large number but just three months ago, Yahoo was trading at a price higher than this premium. If not for a severe sell-off in the technology sector, Microsoft’s bid might have been laughable.

According to Microsoft, synergies through the increased scale, expanded research and development capabilities, higher operational efficiencies and more resources to focus on emerging internet user experiences will generate at least $1 billion annually. This does make sense as Microsoft’s and Yahoo’s market share in web search, 9.8% and 22.9% respectively, has so far failed to threaten Google’s dominance. Together, they might just be able to form a resemblance of competition to Google’s 58.4% market share.

Microsoft’s acquisition makes even more sense when looking at the two firm’s web properties. At the very end is a table of where Google, Yahoo and MSN properties appear within the top five positions of various web applications and portals.

By competing on a totally different field, Microsoft and Yahoo will be able to control web applications which can then be leveraged to maintain or even increase revenue from Microsoft’s core competency of office and operating software. On a different note, Google and Yahoo are also strong in different geographic areas, Yahoo in Asia and Microsoft in Latin America and Europe, and a merger would greatly expand their reach.

There is always an integration risk from failing to absorb its acquisition, even more so with large technology acquisitions where there is a graveyard of previous failures. However Microsoft has undergone careful thought and valuation before going through with its bid and with the online advertising market projected to double in the next three years, the return might just justify the risk.

The Chinese Stock Bubble

A little article I wrote for the trading floor newsletter at the beginning of the year. With the Shanghai Composite Index already down 12%, it doesn’t seem such a bad analysis after all…

The Chinese Stock Bubble

Three decades of solid double-digit growth in GDP has made China the third largest economy in the world. Yet despite the shape of the economy, it wasn’t until 2006 till the Chinese stock markets became recognized on the world stage. The Shanghai Composite Index averaged a 113.6% annual return over the last two years to make it the fifth largest stock exchange in the world by market capitalization. Such returns seem neither sustainable or realistic indefinitely, and this explosion has the earmarks of a market bubble.

After five consecutive years of negative growth in the stock market, the Chinese government lifted a ban on IPOs in the middle of 2006, and relaxed restrictions to encourage many of the largest Chinese companies who previously were only listed on the Hong Kong or/and American Stock Exchanges to start raising funds in mainland China. These new entrants may have brought in repute into the markets of a country where corruption is rife. Perhaps this is what triggered what Alan Greenspan termed as “irrational exuberance”. No market bubble has occurred without investors speculating and driving up prices beyond rational expectations of its real worth. China’s new found wealth meant a burgeoning middle class who had no place to put their savings. Constricted to just investments in mainland China, the stock market now seemed the best and safest place to put your savings, and everybody was doing it. There was also a commonly-held belief that the government, who holds majority holdings in many benchmark companies, would not let the markets crash before the Beijing Olympics due to the devastating effect it might have on its economy and reputation.

Not many countries have had a major index quadrupled in two years. Yet with the Shanghai Composite and Shenzhen Composite having P/E ratios of 65 and 72 times trailing earnings respectively, the markets are undoubtedly due a market correction, a fact not missed by the government. Chinese government has a lot more control and has been trying its best to control the euphoria in the stock market, even going as far as to warn investors that a bubble might be forming and to be increasingly cautious. The markets themselves have a few measures in place that might help mitigate the effects of a correction. The two Chinese stock exchanges have implemented caps which prevent stocks from rising or falling more than 10% a day by halting any trading on that stock. Short-selling is also illegal in China due to a suspicion that it might exacerbate market crashes. And of course the classic move of increasing interest rates hasn’t been neglected with interest rates raised six times in 2007 to a nine-year high of 7.47 percent. Yet despite all their efforts, the markets have continued to grow unabated, market forces prevailing in spite of the government’s actions. It certainly seems inevitable that the Chinese markets will crash; the only question left unanswered is when it will occur, and how bad it will be.